How Leveraging Alternative Assets and Modern Portfolio Theory Can Help Investors Improve Returns

The recent and volatile twists and turns of today’s stock market undoubtedly have individuals confused as to where it might be headed next – and perhaps a bit nervous about their long-term investments and retirement nest eggs. Depending on what you read or watch you might hear a variety of advice about what to do with your investments in light of this persistent tumult. As a serial entrepreneur with more than 20 years’ experience in real estate and investing, the one investment strategy I have long employed is diversification. That’s why at Realized, we leverage Modern Portfolio Theory, or MPT, when creating our clients’ investment portfolios.

From my perspective, true diversification is more than just a balance of conventional investments spanning cash, equities and fixed income. There’s a vast universe of alternative investments out there that may suit your risk profile and are worthy of a closer look. Let’s discuss.

Modern Portfolio Theory was created by Harry Markowitz, a Nobel Laureate, and first published in his paper “Portfolio Selection” in the 1952 Journal of Finance. Markowitz summed it up this way, “A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”

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MPT is an investment strategy that helps investors manage investment portfolio risk while at the same time seeking increased returns using diversification. MPT posits that markets are more efficient and reliable than investors. According to Markowitz’s theory, based on increasing the level of risk that you’re willing to take, you can potentially get better returns.

MPT assumes that investors want the highest returns with the least amount of risk. But risk and reward when it comes to investing have a positive correlation; when you invest in low-risk assets like bonds, your returns will generally be lower than when investing in higher-risk assets like stocks. Investors have to find a balance between risk and reward. MPT says this balance can be achieved via diversification.

At Realized, we believe a balanced portfolio that contains a variety of asset types, including alternative investments like real estate, can help investors improve returns while managing risk. Let’s explore some alternative investments to consider in a portfolio and the potential return an investor can expect by including them in their diversified strategy.

Defining Alternative Investments

Conventional investments are things like stocks, bonds, cash and cash alternatives, such as money market accounts and CDs. Alternative investments are things that don’t fall into any of those categories. Alternative investments can include:

• Real estate (Delaware Statutory Trusts, QOZs, raw land, co-working spaces, retail spaces, etc.)
• Hedge funds
• Private equity
• Cryptocurrencies
• NFTs (Non-fungible tokens)
• Collectibles
• Commodities

In the past, alternative investments were only of interest to high-net-worth and institutional investors. But in recent years, they have become more mainstream and begun attracting the attention of everyday investors too.

Keep in mind that alternative investments are riskier than conventional ones; they don’t have a long track record and, in some cases, are less regulated and transparent. And alternative investments are often less liquid than conventional assets. But alternative investments can offer higher returns, and because they’re typically not correlated with the stock market, they can help protect your portfolio from market ups and downs.

Alternative Investments and Modern Portfolio Theory

In 1952, diversification essentially meant a mix of just two asset classes: stocks and bonds, usually in a 60/40 split of stocks and bonds, respectively. In current times, we believe a diversified portfolio should include more alternative investments, including real estate.

Current MPT dictates that a diversified portfolio can contain between 10% and 20% alternative investments, including real estate. Most individual investors are falling well short of that, devoting only 5% to alternative investments, while pension funds and endowments are well above that, with 30% and 50% respectively invested in alternatives. These large investors gravitate to alternatives – and real estate in particular – to further diversify their portfolios and because of the income and yield opportunities real estate provides.

Why Use Real Estate as an Alternative Asset

Based on data from Griffin Capital, alternative assets can help enhance portfolio return while managing overall risk and volatility of an investment portfolio. Over the past 20 years, a 60/40 portfolio of stocks and bonds has shown returns around 6.86%. However, by modifying that split to 55/35/10 of stocks/bonds/real estate, returns increased to 7.06%. Additionally, adding real estate to portfolios decreased the volatility from 9.90% in the 60/40 breakdown to 9.15% in portfolios with 55/35/10.

While inflation hasn’t been a problem since the Great Recession, it can be harmful to fixed-income investors. Inflation could mean an increase in bond yields, which lowers the valuation of an existing bond portfolio and eats into real returns. We believe this makes the case for an increasing need of more portfolio diversity, including alternative investments.

Alternative Assets and Your Portfolio

At Realized, we believe that creating a portfolio that contains diverse, tax-deferred, commercial real estate investments can help investors reach their financial goals. Using the principles of what we call Investment Property Wealth Management®, or IPWM™, investors can leverage tactics such as 1031 exchanges when selling their investment properties, allowing them to keep more of their money working toward their financial goals. Using a 1031 exchange allows investors to exchange their investment property for a like-kind replacement property and deferring capital gains taxes at sale. Our team helps investors through the 1031 exchange and develops custom portfolios that contain fractional investment into commercial grade properties, granting investors access to properties that may have been outside their reach on their own.

These alternative assets, such as Delaware Statutory Trusts (DSTs), can not only provide an alternative revenue stream and help diversify your portfolio, but they can also create a tax-deferred way to keep more of your profits working for you over the long run. In addition, by creating a diverse portfolio comprised of different property types throughout the country, investors are better able to manage risk.

When building out your investment portfolio, we recommend including real estate alongside stocks and bonds to potentially achieve a greater level of return.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

David Wieland is founder and CEO of Realized Holdings, a technology-enabled platform providing real estate wealth solutions to individuals and families that own legacy properties and other appreciated financial and capital assets. Investors use the Realized platform to transfer wealth from legacy properties and assets into passive commercial real estate portfolios — comprised of DST and QOZ investments and customized to their specific needs. To learn more, visit www.realized1031.com.